Brace for More Market Volatility in the Second Half of 2013

Investors, buckle your seat belts. Markets in the second half could be driven by more volatility, though most strategists expect equities to ultimately end the year higher than their current levels.

"The recent volatility in stocks and bonds will likely be with us for the foreseeable future (at least a few months)," wrote strategists Stuart Freeman and Scott Wren of Wells Fargo, which has a year-end target of 1,650 to 1,700 on the S&P 500. "But we continue to believe any pullback is an opportunity to add to stocks in sectors sensitive to a continuation of the economic recovery. Our recommendation is to put money to work now."

Strategists expect markets to continue zigzagging near-term, as investors struggle to adjust in the face of a rising yield environment and grapple with the reality that the Federal Reserve could begin to wind down its $85 billion a month bond-buying program before 2014.

"We're in for a long-range-bound summer," warned Tim Biggam, chief market strategist at MoneyBlock. "Volume is still anemic, and the catalyst that drove us to these levels [the Fed] may not be there anymore."

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Major averages have been on a roller-coaster ride since Federal Reserve Chairman Ben Bernanke told Congress in May that the central bank may reduce the pace of bond purchases in the next few meetings if policymakers see indications of sustained economic growth.

After the news, the S&P 500 index fell as much as 7 percent from its intraday record high in May. The Dow Jones Industrial Average has logged triple-digit moves in 15 of the 19 trading sessions in June, the most in a month since October 2011. And the 10-year bond yield climbed as high as 2.66 percent earlier this week.

Despite the swings, the Dow industrials and S&P 500 are still poised to churn out decent gains of nearly 3 percent for the second quarter. So far this year, both market indicators have rallied more than 13 percent each.

"When the Fed does eventually begin to reduce the pace of QE, they will just be taking their foot off the accelerator and certainly not pushing down on the brake any time soon," wrote the Wells Fargo strategists. "Investors are continuing to take relatively more interest in more cyclically oriented stocks versus defensive ones."

Also in the bullish camp, Sam Stovall, chief equity strategist at S&P Capital IQ, said the firm raised its 12-month target for the S&P 500 to 1,780 from 1,670.

"In the coming year, we expect to see S&P 500 multiple expansion as investors become more convinced of sustainable economic growth and [earnings] increases, and more comfortable with the gradual unwinding of Fed stimulus," Stovall wrote in a recent note. "We also increased our recommended exposure to U.S. equities to 50 percent from 45 percent, suggesting that investors use projected near-term price declines as opportunities to add to holdings, while reducing the cash exposure to 10 percent from 15 percent."

History shows that strong market momentum in the beginning of the year bodes well for a robust annual performance, Stovall said.

"We have momentum from a strong start to the year—there have been 26 times since World War II that the market was up both January and February, and in all cases, the market posted an average total full-year return of about 24 percent," he noted.

In the meantime, strategists such as Biggam recommended that investors take advantage of the recent sell-off in commodities.

"Gold, silver, and other commodities have felt the brunt of the selling," he said. "So if you're not exposed to the metals complex, it's not a bad time to be looking to add to your positions, unless we head into a huge deflationary spiral."

In addition, Biggam said, investors should consider adding options to their portfolios.

Making Sense of Markets Swings

Jim O'Shaughnessy, chairman and CEO of O'Shaughnessy Asset Management, outlines his strategy for navigating volatility and for investing in emerging markets.

"The nice thing about options over stocks is that whereas you need movement to make money in stocks, you can still make money in options in a sideways, range-bound market," he said. "It's a nice blend in an overall portfolio."

Some strategists expressed caution about the second half. Bruce McCain, chief investment strategist at Key Private Bank, suggested that gains for the year have mostly been made and that investors should prepare for an upside at the beginning of 2014.

"The market's still reasonably valued, but expectations are high for the end of the year," he said. "Slow and steady growth can allow us to achieve modest appreciation through year-end, particularly if we pull back toward the 1,500 to 1,550 area on the S&P 500 over the next coming weeks. You're likely to be disappointed that we're not seeing faster growth in the economy. … But we're setting up for a more decent 2014."